Islamic venture capital Key to knowledge-based economy

FAILURE is a mark of success in venture capital.

Today, Islamic venture capital is a feel good theory presented at conferences about the lofty goals of this niche market with the focus on the formalism of structuring and screening. Its impact investing, yet we see it as a cost (at best) and a write-off (at worst).

The chairman of Malaysia’s Securities Commission, Zarinah Anwar, stated in a keynote speech in 2007, “… how can Malaysia distinguish itself in the emerging market VC (venture capital) pool? Our belief is that Islamic VC provides that distinguishing factor.” Obviously, the industry needs to catch-up to the vision of the chairman.

To date, Islamic finance has missed two important opportunities: Addressing the “have nots” (micro-finance) and deploying the funds of the “haves” into Islamic VC funds. Yes, VC is labour intensive requiring specialised skills, entails active risk capital as part of portfolio and a long-term play, much like Sukuk, in hold to maturity portfolio or lock up periods in real estate and private equity.

Walk the talk

However, it is time for Islamic finance to “walk the talk” of venture capital. Others have written more eloquently on the syariah modes of contract of Islamic VC, preferred share issues, etc, my interest is macro (industrial policy like) and multiplier impact (knowledge-based economy) of Islamic VC in Muslim countries.

It’s an asset class whose time needs to arrive. It’s the authenticity that Islamic finance needs as it’s the pre-condition foundation for innovation.

Young technology (Muslim) graduates in OIC countries (Organisation of Islamic Cooperation) have typically opted for working in multi-national corporations and government jobs, and rarely do we hear about friends/colleagues considering “garage souk” start-ups.

Islamic VC is not about sending Muslim (country) money to western market VC-based funds as passive investors in selected sectors and (hoped for return) profits are remitted to the Muslim country funds. Yes, VC does not exist in Muslim countries, but this “cycle of portfolio only returns” has to stop somewhere and sometime.

OIC tech parks

Islamic VC in Muslim countries is not about setting up technology parks with names linked to “Silicon Valley” without a supportive infrastructure. Hence, becoming a real estate tenant occupation play.

Furthermore, with the focus on crowded ICT and the “hot” social media, it becomes another offering into the sea of offering, hence, it does not stand out.

For example, Google’s recent announcement in Egypt, called Ebda2, is supported with seed money and mentoring to take advantage of the entrepreneurial energy and opportunity fanning across Egypt, if not the Maghreb. The dynamics of the Muslim world entails the need to look beyond and addition to the next Twitter, Facebook, Youtube and so on.

Yes, ICT/social media is needed, but are they vital for gross domestic product (GDP) diversification and growth and pursuit of knowledge-based economies?

If the leading Muslim countries, like Malaysia, Turkey, the UAE, etc, are to increase the per capita income by 30-50 per cent by 2020, diversify their economies from commodities, contribute to capital market development, reduce and reverse capital and brain drain, move away from pep talks and motivational speeches, and so on, then outside the box thinking is the need of the hour, as the hour of the day is continually passing us by.

A VC eco-system needs to be the collective mantra of the leaders and the led. The Muslim world cannot build a “silicon valley” by simply calling it — silicon valley, alley or oasis. We must acknowledge the risk (less than some of the white elephants projects), return (knowledge-based economy) and reward (first Islamic VC hub).

Indicator of innovation

Patents are an indicator for innovation and knowledge-based economy. A 2006 article in Dinarstandards, Intellectual Property Gaining Protection in the Muslim World, shows how Malaysia heads the list of OIC countries (Table 1) with 547 patents (granted in the US) during the 27-year period.

Putting it in prospective, Japan had 547,865 patents granted out of total 3,101,719 during the same time period and OIC countries (totalling 1,542) had a meager 0.05 per cent.

State of Islamic VC

But, where is Islamic venture capital in the Muslim world? There are Islamic VC associations (Gulf Venture Capital Association or Malaysian Venture Capital and Private Equity Association (GVCA), VC Funds (Musharaka Venture Management Sdn Bhd) and venture capital bank (VC Bank), etc. But, results are under-whelming as very few Islamic VC conferences, announcements of investing and exits or coverage in the media.

VC eco-system

To address the criticism of the present Islamic investing business model, exporting capital and importing returns, Islamic VC needs to be linked with public-private partnership to establish a framework for a knowledge-based OIC country economy.

At the KL International Venture Capital Symposium, I have been asked to present on the Islamic VC eco-system in Muslim countries. The approach is to link Islamic VC to investing in companies or technology transfer to address some of the major illnesses in OIC countries as part of medical tourism and housed in technology parks while working with research universities.

Yesterday’s AIDs awareness is today’s non-communicable diseases (NCD), obesity and diabetes (Type 2) contributing to heart disease and stroke.

For example, the sedentary lifestyle and nutritional transition has made the Gulf region the fastest “NCD hub” in the world, and there are massive costs for cash-strapped governments, therefore, interesting opportunities (in the billions) for Malaysia.

Thus, Islamic finance must think about financing the health of mankind, whilst contributing to a knowledge-based economy.

The writer is global head of Islamic finance for Thomson Reuters based in New York

 

http://www.btimes.com.my/Current_News/BTIMES/articles/20111011000900/Article/

ISLAMIC BANKING IN INDIA – Legal Issues

After discussing the different principles of Islamic banking, this is an attempt to explore the feasibility of Sharia banking in India. The rise of “interest” as a blood sapping social evil is alarming. To get rid of this menace and save the nation from the clutches of interest, suitable amendments should be made in the Banking Act. Indira Gandhi’s slogan, “Garibi Hatao” and “Roti,Kapda Aur Makaan” as enunciated by Zulfikar Ali Bhutto are still relevant today as it was in the early seventies.

Yet even today, horrendous disparities exist between different segments of the Indian society. The majority of the unorganized sector; workers, semi-skilled persons, small farmers are all non-bankable. .Access to finance by the poor and the vulnerable groups is a prerequisite for poverty reduction and social cohesion.

Such “financial apartheid” is one of the main causes of exclusion of the majority of the population in terms of growth. Government must provide the disadvantaged classes with the tools they need to improve their condition.The Indian banking sector has opened up considerably in the past decade or so and openness to interest-free banks is a logical next step.

Islamic banking is one way to ameliorate the disadvantaged classes. The potential benefits of allowing Islamic banking include; decreased economic disparity between the haves and the have nots, better integration, and consequently accelerated economic growth. Government of India can leap a step closer towards the fulfillment of Indira Gandhi’s much cherished dream of “Garibi Hatao” by reforming its banking sector and allowing the establishment of Islamic Banks.

To get a clear picture, let us analyze the position of Islamic banking in India on SWOT(Strength, Weakness, Opportunity and Threat) Scale. SWOT analysis will help us to logically examine the chances if this concept would flourish or flounder in India.

STRENGTH

Islamic Banking will unequivocally ameliorate the deplorable condition of the poor and marginalized segments of society. Banking products which comply with Islamic law are becoming increasingly popular, not only in the Gulf countries and far eastern states like Malaysia, but also in other developed markets such as the United Kingdom. Reputed banks like Standard Chartered, Citibank, HBSC are operating interest free windows in several West Asian countries, Europe and USA.   There is a huge potential market in India for Islamic banking products.

We have seen the fall of giants in the world of financial sector like Lehman Brothers in the aftermath of the US sub-prime mortgage crisis. Therefore, it is of paramount importance to be strict about credit rating system, to circumvent any chance of  further bankruptcy. Since Islamic banking adheres to strict credit rating system and prohibits indebted economic agents to avail more debt finance, it could save our financial and economic enterprises from bankruptcy. Interest is strictly proscribed in Islamic banking. Principles of equity finance abhor financing the indebted enterprises thereby arresting the chances of bankruptcy to  great extends. Under Islamic banking, equity finance needs cost yield and pre-rating analysis of projects. It thus considerably subdues the mindless competition in financial sector to get more credit shares and tends to provide stability in the financial market.

Islamic banks are unaffected by the subprime mortgage crisis. In fact, now many non-Muslim countries are turning up to Islamic banking as they are immune against such crisis due to inherent business ethics within Islamic banking.

Moreover, Islamic banking helps the weaker and hapless section of the society through various financial products. Islamic banking finances (through its Joint ventures,partnerships and leasing)are provided by investors or banks to the borrowers with a condition that financial risk is to be borne by the investors, and other risks to be borne by the borrower.

This helps even the indigent and vulnerable to get finance at a no risk and cost basis, but definitely requires other credits like strong business proposal, rational planning, skilled hands and specialized art to attract the financier. Better business proposals succeed in fetching funds as opposed to the projects with comparatively poor propositions. Such inclusive growth will aggrandize   the Indian economy.

A bank in India cannot raise deposits without promising a specified rate of return to depositors, but under Sharia, returns can only be determined post-facto depending on profit. Also banks have to maintain a Statutory Liquidity Ratio (SLR), which involves locking up a substantial portion of funds either as cash, gold or in government securities. Such cash will not get any return,  keeping it in gold is risky as it could depreciate and government securities come with interest.

Moreover, Islamic banking can eliminate unaccountable economic activities, as every economic activity has to be financed through legal contract and physical verification of real assets under contract. There is no room for diversion of funds. Therefore, investment in consonance with Islamic banking principles will surely boost the engine of economic growth in our country.

The high powered Raghuram Rajan Committee draft Report as released on 7th April 2008, strongly suggested interest-free banking as a part of recommendations made for financial sector reforms. The Committee postulates that interest free banking is another area that falls broadly in the ambit of financial infrastructure.Certain faiths prohibit the use of financial instruments that pay interest.

The non-availability of interest-free banking products (where the return to the investor is tied to the bearing of risk, in accordance with the principles of that faith) results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith.

This non-availability also denies India access to substantial sources of savings from other countries in the region. While interest-free banking is provided in a limited manner through NBFCs and cooperatives, the Committee recommends that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system.

This is in consonance with the objectives of inclusion and growth through innovation. The Committee believes that it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact.

WEAKNESS

Indian banking laws do not explicitly prohibit Islamic banking but there are provisions that make Islamic banking almost an unviable option. The financial institutions in India comprises of Banks and Non Banking Financial Institutions. Banks in India are governed through Banking Regulation Act 1949, Reserve Bank of India Act 1934, Negotiable Instruments Act 1881, and Co-operative Societies Act 1961.

Certain provisions regarding this are mentioned below

  • Section 5 (b) and 5 (c) of the Banking Regulation Act, 1949 prohibit the banks to invest on Profit Loss Sharing basis -the very basis of Islamic banking.
  • Section 8 of the Banking Regulations Act (BR Act, 1949) reads, “No banking company shall directly or indirectly deal in buying or selling or bartering of goods…”
  • Section 9 of the Banking Regulations Act prohibits bank to use any sort of immovable property apart from private use –this  is against Ijarah for home finance
  • Section 21 of the Banking Regulations Act requires payment of Interest which is against Sharia.

As regards to partnership by Islamic banks in a firm, the bank has to make sure that the manager does not avoid his responsibilities or obtain other non-pecuniary benefits at the expense of non-participating partners and ensure the veracity of the profit statements. Monitoring of data about firms in which Islamic bank invests would involve exorbitant cost.

However, Islamic banks need to set up monitoring cell to keep them informed of the internal function of their joint venture. The implication is that banks and entrepreneur have to function very closely.

Islamic banking needs to introduce corporate governance with transparent accounting standards. It needs to perform detailed evaluation before embarking Profit Loss Sharing Scheme, which demand a pool of highly trained professionals. The imparting of professional training is costly. Detailed principles are still to be laid down and techniques and procedures evolved to carry them out. It is only after the satisfactory achievement of these that proper training can begin.

It is observed that inability to evaluate a projects’ profitability has tended to act against investment financing. Some borrowers frustrate the banks appraisal efforts as they are reluctant to provide full disclosures of their business. These exercises are not limited to relatively few large loans but need to be carried out on nearly all the advances made by the bank.

Yet, widely acceptable and reliable techniques are yet to be devised.Moreover, the borrowers do not observe business ethics which make it difficult to establish close bank-clientele relationship – a condition for successful Islamic banking. Adverse selection has been one of the major impediments in the world of Islamic banking.

Among the other disincentives from the borrower’s point of view are the need to disclose his accounts to the bank if he were to borrow on the Profit Loss Sharing basis. However, many small-time businessmen do not keep any accounts, leave alone proper accounts. And large conglomerates do not like to disclose their real accounts to anybody. The widespread lack of business ethics among certain business community will be another major hurdle in the path of Islamic banking in India.

The practices in use by the Islamic banks have evoked questions of morality. Some critics view Sukuk(Islamic Bond) as unIslamic in nature. Others criticize that financing through the purchase of client’s property with a buy-back agreement and sale of goods to clients on a mark-up, involved the least risk and are closest to the old interest-based operations.

Bai’ mu’ajjal (sale with deferred payment) and Murabaha (cost-plus financing) are permitted in the Sharia under certain conditions.What is being done in many countries are fictitious deals which ensure a predetermined profit to the bank without actually dealing in goods or sharing any real risk. This is against the letter and spirit of Sharia.

OPPORTUNITY

India with a 15% Muslim population, the highest in a non-Islamic country and  second  highest in the world offers huge opportunities to exploit . The size of the market will be very large as the Indian population is above 100 crore and Muslim population itself is about 15 crore and majority of them, in the name of religious faith, are looking for interest free banking and finance.

It is pertinent to mention here that Islamic banking is not meant for Muslims only but non Muslims may also avail the benefit of it. And it is feasible to have a parallel banking system based on Sharia along with a conventional one.

After 9/11, most of these countries started pulling out their investments from the US and Europe because of the fear of freezing of assets. Another reason could be the slowdown in the economies of western countries. A growing Indian economy has created a huge enthusiasm among Islamic nations as it sees the unlimited opportunities it can avail. In fact, five Indian companies, Reliance Industries, Infosys Technologies, Wipro, Tata Motors and Satyam Computer Services figure in the Standard & Poor’s BRIC Sharia Index.

Eleventh Five Year Plan envisages inclusive growth with development in all sectors of economy. Islamic banking is an effective mechanism to subjugate the liquidity and inflation problems along with allowing inclusive growth. For real inclusive growth, we have to ensure increase in income and employment status of workers in all segments.

If Islamic banking is introduced, the inadequate labor capital ratio, for informal sector workers associated with agriculture and manufacturing industries could be resolved through equity finance, which might be a revolution in our agriculture and unorganized sector.

With improved labor capital ratio, our vulnerable workers associated with agriculture and unorganized sector might be able to compete effectively with the formal sector workers. Thus Islamic Banking may financially empower majority of Indian workers.

Islamic banking may induce our political leaders to substitute grants and subsidies with equity finance schemes through specialized financial institutions because equity finance allows access to credit without debts of borrowers.

Equity Finance helps achieve self-reliability which never comes through grant and subsidies. Islamic banking should not be a religion based banking business, but could be profitably used to resolve our issues pertaining to economy.

Moreover with introduction of Islamic banking, Indian government will certainly gain diplomatic advantages to make financial dealings with Muslim dominated nations especially to attract trillion dollars of equity finance from the gulf countries. This is more important after the fall of the titans like Lehman Brothers because it reflects the economic downturn in the west and the need of alternative sources of FDI for the Indian economy. India needs to provide a congenial economic environment to attract the financial inducement from the Gulf region.

Islamic scholars have defined market instruments in length and they have permitted with some conditions to have investments in stock market .Certain broad criteria are:

  • The company’s activities should not include liquor, pork, hotel, casino, gambling, cinema, music, interest bearing financial institutions, conventional insurance companies, etc.
  • The total interest bearing debt of the company at any point in time should remain below one third of its average market capitalization during the last twelve months.
  • Its aggregate of account receivables should remain below 33% of total assets.
  • If company has any interest bearing income it should not be more than 5% in any condition.

While Sharia compliant investment avenues are now becoming available in most countries, India has not seen large-scale development. To estimate the scope of Islamic investment opportunities in the Indian stock market, it is imperative to examine stocks that conform to Islamic Shariah principles “Out of 6,000 BSE listed companies, approximately 4,200 are Sharia compliant.

The market capitalization of these stocks accounts for approximately 61% of the total market capitalization of companies listed on BSE. This figure is higher even when compared with a number of predominantly Islamic countries such as Malaysia, Pakistan and Bahrain. In fact, the growth in the market capitalization of these stocks was more impressive than that of the non-Sharia compliant stocks.

The software, drugs and pharmaceuticals and automobile ancillaries sector were the largest sectors among the Sharia compliant stocks. They constitute about 36% of the total Sharia compliant stocks on NSE. Further on examining the BSE 500 the market capitalization of the 321 Sharia compliant companies hovered between 48% and 50% of the total BSE 500 market capitalization.”

Another opportunity is mutual fund which is based on 100% equity. These funds are invested in different sectors like IT, automobile telecommunication, cement. In fact, Tata Mutual Fund made a pioneering attempt when, at the instance of the Barkat and some other Islamic financial group, it launched Tata Core Sector Equity Fund in 1996 . This scheme was specially tailored keeping in view the Muslims’ inhibition of dealing with interest bearing and haram investments. This scheme surprised many by being able to raise Rs. 230 million from the public.

Moreover, large number of Muslims who are considered unworthy of credit by commercial banks would welcome Islamic banking. People prefer to put their money in gold or jewellery, which is the worst kind of investment from the economic point of view. Some Islamic societies in India accept deposits and lend money, but can’t make a business out of it because of the Sharia’s prohibition of interest.

And they are not able to convert themselves into banks because the government will not permit any form of banking without interest. Some of them have collected crores in interest-free deposits, but they do not have any avenue to invest that money,

THREATS

Islamic banking could be a huge political issue. Certain parties might abhor the use of the word “Islamic” and could term it as anti-Indian. They might argue that the very concept of Sharia banking would go against the secular fabric of our country. We are already facing problems pertaining to Muslim Personnel Law and trying to implement Uniform Civil Code.

Therefore, at this juncture, if we introduce Islamic banking in India, it will create more problems than solving the issue. Moreover, it may bring financial segregation in the economy. The compartmentalization of Sharia compliant and Non Sharia Compliant banking might be used by certain vested interest to communalize the   finance sector in India. Such questionably sane but unquestionably dangerous trend must be prevented with full might.

CONCLUSION

Islamic banking is at an incipient stage. The existing legal framework does not permit Islamic Banking. Only selective activities like equity investment is possible, while trade finance aspects like taking title to goods is not possible. A lot of amendments need to be carried out in the prevalent legal set up. Appropriate models need to be selected and implemented to suit society’s diverse financial needs.

Islamic Bank of Britain, Islamic banks of Thailand, Singapore and USA may be glaring models for Indian bankers. The reputed domestic and international banks along with the collaboration of RBI should be involved in the process of determining and implementing Islamic Banking products.

The importance and relevance of Islamic banking in India in the context of “Financial Tsunami” that has taken place in recent times further enhances the need of Sharia banking. Also the political parties need economic rationality to convince majority of voters that Islamic banking is not being introduced to please Muslim voters but to genuinely boost faster and inclusive growth for the Indian economy.

Obnoxious politics in the name of religion must be avoided. I personally believe to refer ‘Islamic Banking’ as ‘Interest Free Banking’ so that it could be looked through the broad economic kaleidoscope and not a narrow religious prism.

With only minor changes in their practices, Islamic banks can get rid of all their cumbersome and sometimes doubtful forms of financing and offer a clean and efficient interest-free banking. Participatory financing is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects.

This is an additional service that Islamic banks offer over and above the traditional services provided by conventional commercial banks. Such a system will offer an effective banking system where Muslims in India may invest in pursuant to Islamic principles and the rest may have an alternative to interest bearing conventional banking. Both systems can co-exist.

Let the people of the largest democracy decide democratically which one they should bank upon. The young sapling of Islamic banking must be nurtured by the Government so that the country may reap the benefit of its fruit in the coming period.

Syed Burhanur Rahman, Attorney,New Delhi

Syed Burhanur Rahman is an alumnus of St. Stephen’s College and Campus Law Center,Delhi University.A Quiz aficionado,he has featured in premier T.V Quiz shows including Mastermind India(BBC),University Challenge Quiz(BBC) and Nat Geo Genius(National Geographic Channel).

An Attorney working with INDUS G & D Law(Delhi),his practice areas include Corporate Law,IPR and Taxation Law

http://www.yourstory.in/resources/legal-talk/1775-islamic-banking-in-india-

Islamic Banking – An Emerging Trend – India

(co authored by-Swati Mantri & Priya Dixit)

by nehavnilawar on February 27, 2010

Islamic banking also known as “interest-free banking” plays a dominant role in working of the banks in Islamic countries.

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic Law [Shariah].

Shariah prohibits the payment or acceptance of interest fee for the lending and accepting of money respectively, {Riba, usury} for specific terms, as well as investing in businesses that provide goods and services considered contrary to its principles [Haraam, forbidden.]

Say, a customer buying a home with bank funds, will not ‘borrow’ from the bank and service it through equal monthly instalments. Instead, the bank will purchase the property and then rent or lease it out to the customer. Once the bank recovers the investment, it will transfer the property to the customer at a reasonable rate.

The basic idea behind such practice is to treat all, rich or the poor equally and to bring about equal distribution of wealth among all classes of people.

History:

The first experiment with Islamic banking was undertaken in Egypt undercover, without projecting an Islamic image. This experiment lasted until 1967 by which time there were 9 such banks in the country. These banks which neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their depositors. In the 70’s changes took place in the political climate of many muslim countries so that there was no longer any strong need to establish Islamic financial institutions undercover.

A number of Islamic finance banks came into existence throughout the Middle East e.g., The Dubai Islamic Bank (1975), The Faisal Islamic Bank of Sudan (1977), The Bahrain Islamic Bank (1979), fostering trade and business activity. In Spain and the Mediterranean and Baltic states Islamic merchants became indispensible middle men for trading activity. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financers and businessmen.

The revival of Islamic banking coincided with the world wide celebration of the advent of the fifteenth century of the Islamic calendar [Hijra] in 1976. The boost received by the oil producing countries due to rationalization of oil prices led Muslims to strive to model their lives in accordance with the ethics and principles of Islam.

Principles:

The underlying financial principles in Islamic finance have remained unchanged historically since their development over 1,400 years ago. The basic principles underlying Islamic banking are profit and loss sharing and prohibition of interest (Riba).

  • Prohibition of Interest:

The prohibition on paying or receiving of interest is based on the Islamic tenet that money is only a medium of exchange it has no value in itself and therefore should not be allowed to give rise to more money via fixed interest payments put in bank or lent to someone. Human effort, initiative and risk involved in a production venture are more important than the money put in it.

Interest can lead to injustice and exploitation in society. The Quran characterizes it as unfair as implied by the word ‘zulm’ (oppression, exploitation). Money is intended to be means of exchange, and interest represents an increase in money itself, hence of all ways of getting wealth this is the most contrary to nature. – Aristotle.

  • Profit-and-loss-sharing :

While Islam employs various practices that do not involve charging or paying interest the Islamic financial system promoted the concept of participation in a transaction backed by real assets, utilizing the funds at risk on profit–and–loss–sharing basis. Such modes used by Islamic banks are known as Musharakah (Joint Venture) and Mudarabah (profit sharing)

The concept of profit and loss sharing is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management.

  • Rules of permissibility:

Muslims believe that all things have been provided by God and benefits derived from them are for man’s use and so they are permissible except those prohibited in Quran.

When guidance is not clearly given in Quran it can be sought from other sources of law like, ‘Fiqh’ which means understanding.

Prohibition includes a number of key principles like:

i. Transactions in unethical goods and services

ii. Earning returns from a loan contract (Riba/Interest)

iii. Compensation-based restructuring of debts

iv. Excessive uncertainty in contracts (Gharar)

v. Gambling and chance-based games (Qimar)

vi. Trading in debt contracts at discount.

vii. Forward foreign exchange transactions.

Scenario Worldwide:

The global market for Islamic financial services, as measured by Shariah compliant assets has estimated growth by over 10% a year from about $150billion in the mid-1990s.

Islamic commercial banks accounted for 75% of the assets and investment banks, 13%. The balance is made up by Sukuk issues.

Emerging centers of expertise :

Bahrain, Dubai/UAE and Kuala Lumpur have strong historical positions and future ambitions as centers for Islamic financial services. Riyadh, Qatar, and Singapore also have aspirations to become centers for Islamic finance. London is positioning itself as the gateway to Islamic finance in Western Europe. The market is currently most developed in Malaysia, Iran and the majority of countries that form the Gulf Co-operation Council (GCC).

However, Islamic finance is moving beyond its historic boundaries in these countries into new territories both within and outside the Arab world. Initiatives are on to develop Islamic finance in the UK. The UK, in 9th place, is the leading Western country with $10billion of reported assets, largely based on HSBC Amanah.

Key future markets include:

  • Arab countries such as Egypt, Turkey, Lebanon and Syria.
  • Asian countries such as Indonesia, which has the largest indigenous Muslim population in the world, and China.
  • Western countries in Europe and North America. Countries such as the US, France, Germany and the UK each have indigenous Muslim populations of between one and five million. Moreover, the customer base in Western countries is not necessarily restricted to Muslims, other customers may be attracted by the ethical and environmental basis of Islamic finance.
  • Malaysia and Pakistan have over 15 banks supplying Islamic financial services; Kuwait, Bahrain each have 17; Iran, Saudi Arabia and Bangladesh each have around 10.
  • Market share of Islamic banks in Malaysia and the Gulf Cooperation Council (GCC) is rising. Within the GCC, Kuwait and Saudi Arabia are the countries in which Islamic banks’ market share is highest and has grown the fastest.
  • London has been providing Islamic financial services for 30 years, although only recently this service has begun to receive greater profile.

Success and difficulties in implementation:

  • Islamic banks are evolving financial and investment instruments that are not only profitable but also ethically motivated. The boom in Islamic banking has several reasons, on one hand the industry is young so the growth is natural on the other hand it depends on credit crises.
  • Volatile interest rates, high bank fees and foreclosure in payment defaults make people unhappy of traditional banking system.
  • Islamic banks or banks that offer Islamic banking units, have a market that holds half of oil reserves and whose citizens have an estimated $ 1.5 trillion in private wealth.
  • With great inclusion of muslim youths in the financial sector they can contribute in a better way and Islamic banking can help counter terrorism. One of the main reasons of terrorism is poverty and Islamic banking can alleviate the condition.
  • Islamic banking, because of its value- oriented ethos enables it to draw finances from both Muslims and non-Muslims alike.
  • Islamic banks are popular especially among young Muslims. Internationally Islamic banks appear more resilient to economic turndown and international financial crisis than conventional banks. Islamic finance involves regulatory framework that accommodates financial principles and clear willingness of the government to promote Islamic finance. It also generates employment opportunities at a large scale.

Challenges in development of Islamic Finance :

Despite all the progress Islamic banks have a long way to go. To keep a sustainable growth track, they must address some critical issues involved.

  • One key challenge arises from the varying interpretations of Shariah across regions, countries and sometimes even within the same country. What constitutes an Islamic practice is determined by a bank’s Shariah Council, an independent bank-appointed panel of scholars. Therefore, what is considered Islamic in Malaysia maybe Haraam or prohibited in Saudi Arabia.
  • These absences of uniform standards affect the bank’s ability to replicate and implement Islamic products across geographies, attract external investors and expand to near markets. The Council must approve all innovative products but, without a uniform interpretation, it is difficult for the banks to know whether the committee will give its nod for a particular region or country.
  • Another challenge is of the regulatory frameworks governing these banks. These frameworks are often at variants leading to operational road-blocks. This is further compounded by absence of accounting, auditing, and credit analysis standards for Islamic banks. Not only must they satisfy the Shariah but also need to measure up to national policies.
  • To operate in globalised economy these banks must also meet international requirements. Being part of International Banking Committee also means following corporate governance requirements which have not been designed for Islamic business model.
  • Another cornerstone of global banking is financial risk management which is underdeveloped in Islamic banks since many such instruments are unacceptable under Shariah.
  • The sector also faces IT related challenges due to systematic complexities of this market because core banking solutions are not perfectly tailored for Islamic markets.

Controversy related to Islamic Finance :

In Islamabad, Pakistan on June 16, 2004, members of leading Islamist political party in Pakistan, the Muttahida-Majlis-e-Amal (MMA) party, staged a protest walkout from the National Assembly of Pakistan against remarks by a minority member on interest banking. He was of the opinion that, without interest the country could not get foreign loans and could not achieve the desired progress.

Later, the opposition members responded to the minority member’s remarks by saying that the Council of Islamic ideology had decreed that interest in all its forms was Haraam in an Islamic society. Hence, he said, no member had the right to negate this settled issue.

Current status in India:

India being one of the countries which has not accepted the law relating to Islamic Banking is now introducing proposition for establishing the first ever Islamic bank in Cochin, Kerala.

However, a year ago, the RBI was asked by the government to look into the matter. The members of the committee submitted their recommendations few months ago, but the regulator, perhaps held back by obvious sensitivities, has not yet put the findings in public domain.

While the final form of report is not known, sources said the members have pointed out how Indian banking laws come in the way of various Islamic banking principles.

These are as follows: Al Wadiah (for Saving Bank Account):

  • Section 21 of the Banking Regulation Act requires payment of interest on such deposits; thus, interest-free deposit and simple charging of premium or Hiba is not permissible.
  • Mudarabah (for term deposit or investment): Here again, Section 21 of the BR Act disallows such products where the bank can invest the money in equity funds (in India, equity exposure is determined by a separate set of rules), and the client has complete freedom in the management.
  • Mudarabah, Musharakah (for project finance and SME credit): Sections 5, 6 of the BR Act indicate the forms of business a banking company can undertake and does not allow any kind of profit-sharing and partnership contract, the basis of Islamic Banking.
  • Ijirar (for home finance) : as against Islamic Banking where the banks owns the asset and hold the title, Section 9 of the BR Act prevents the bank from any sort of immovable property other than private use.
  • Istisna (leasing, buyback): Besides the usual curbs on acquiring immovable property offering Islamic banking products many not be bankable due to stamp duty, central sales tax and state tax laws that will apply depending on the nature of the transfer. In the markets like the UK there is separate law that makes it possible to launch Islamic banking products. The BR Act even disallows an Indian bank from floating a subsidiary abroad to launch such products, or offering these through a special window. Thus, the upshot of the findings is that such banking experiment is impossible without a new law and multiple amendments to the BR Act thereof.

Though the RBI study group had earlier rejected the concept of Islamic banking it was given a green signal by the Raghuram Rajan Committee on banking reforms. A report prepared by Ernst and Young was approved by the Kerala industries on August 12, 2009. Its likely that the registration formalities will be completed and the bank will be operational in 2010.

Kerala State Industrial Development Corporation, which is the designated agency for the formation of the bank, will have 11% stake in the proposed banking company. According to the government officials it will be registered as a non banking finance company in the beginning and later get transformed into a full fledged Shariah-Compaliant bank.

However the biggest challenge before the Kerala-based bank will be the formation of a Shariah Supervisory Board, including independent scholars on Shariah and banking business, in order to monitor the activities of the bank.

The islamically based system of finance has proven itself to be entirely feasible and sound. There are many benefits to the development of full-fledged Islamic banks in India which include a potential bettering of the condition of India’s largest minority and better integration of that minority into secular-democratic India. This would also enhance savings across the country and an increase in the national GDP growth rate. Reform, by opening to Islamic banks would be beneficial for all entrepreneurs who have profitable proposals but lack collateral.

Increased political involvement, decreased inequality, business ownership and wealth will all serve towards the growth of our economy. All Indians will benefit from the increase in the GDP, the decrease in welfare expenditure, an increase in tax revenues, creation of new savings, employment opportunities and mobilization of savings. The increased growth would be the outcome of efficient investment allocation provided by Islamic banks.

Conclusion:

The benefits to India of opening itself to full-fledged Islamic banks are significant and numerous enough that the opportunity cannot be easily neglected. India’s banking sector should be reformed so as to allow and encourage Islamic banks to enter the market place. Islamic banks are on the thresh hold of historic opportunity. Oil prices are rising; banks are flush with funds and are driving growth on the back of strong recent performances.

The interpretation of fundamentals of Islamic financial principles and emergence of clear standard and a common framework will help bring about improved management practices at Islamic banks resulting in higher growth and profit margins.

The majorities of Islamic banking clients are found in the Gulf States and developed countries. With 60% of Muslims living in poverty, Islamic banking is of little benefit to the general population. The majority of financial institutions that offer Islamic banking services are owned by Non-Muslims. With Muslims working within these organizations, employed in the marketing of these services, having little input into the actual day to day management, the veracity of these institutions and their services are viewed with suspicion.

One Malaysian Bank offering Islamic based investment funds was found to have the majority of these funds invested in the gaming industry; the managers administering these funds were non Muslim. These types of stories contribute to the general impression within the population that Islamic banking is simply another means for banks to increase profits through growth of deposits and that only the rich derive benefits from implementation of Islamic Banking principles.

The sensitive secular fabric of India can hinder the full-fledged implementation of Islamic finance and can create a controversy on the term “Islamic Banking” itself. As the term refers to the form of banking as Islamic, a reserved impression is cast and not many non Muslims would prefer to opt for it. However if a rational approach is adopted by all without letting the secular aspect affect the banking scenario it will prove to be futile towards higher GDP and betterment of the entire economy.

With around 11% of the Indian population being Muslims, Islamic banking may find enough takers. But given the tedious route for new legislations, it may take a long time to happen. It can prove to be a conducive idea and the government of India can grow one step closer to development of the economy by way of making amendments in the current banking system and adopting Islamic banking.

http://jurisonline.in/2010/02/islamic-banking-an-emerging-trend/


*Students of 4th B.S.L LL.B

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Taken from Asian-Pacific Economic Literature,Vol.2,no.2(Sept 1988),pp.46-62

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Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.

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IFSL Islamic Finance Report, 2008. Author: Duncan McKenzie.

Islamic banking in India-what is the future potential? by Soumik Majumdar Management Development Institute, Gurgaon.

Banking on Faith by Rajashkhara V Maiya and Basudev Banerjee.

Banking on Faith by Rajashkhara V Maiya and Basudev Banerjee.

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Ahmed.Ausuf, (2003) Introduction to Islamic banking in India: Scopes and challenges. Ed.Javed Ahmed Khan (new Delhi: Institute of objective studies)17-18